Hamish McRae: A new rule book for the Eurozone

Economic Studies
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The Independent Online

Meanwhile across the Channel the Eurozone is struggling too to find some way of curbing fiscal deficits. Our own understandable preoccupation with the spending cuts has drawn attention away from efforts by France and Germany to figure out some way of preventing another breakdown in confidence in the Eurozone such as occurred last spring.

Of course this has to be a co-operative effort and the weaker countries have to sign up too but in practice the decision will be taken by the big two. Both countries have financial problems of their own, as has been very evident from the strikes in France, but the plain truth remains that it is they who will have to stump up the bulk of the cash next time a weaker Eurozone member gets itself into trouble.

Something has to replace the Maastricht Stability and Growth Pact not just because it has failed, which was self-evident even during the boom years, but because it was constructed in a perverse way. You may recall that there were two requirements in it, both designed to make sure that countries followed a responsible fiscal policy. One was that national debt should not be higher than 60 per cent of GDP; the other that the annual deficit should not be higher than 3 per cent of GDP. The first was always for the birds because a number of countries, notably Italy, had much higher debt levels and were still allowed to join the euro. But the second was seen as an acceptable ceiling. But, and this has been the big design flaw, to have a ceiling that ignores the economic cycle is absurd. You should not try to tighten policy in bad years and you should tighten more in good ones. You can justify a deficit of 3 per cent, maybe even a bit more, in a slump but to achieve that you probably need to be running surpluses in a boom. As it turned out even Germany was above the 3 per cent limit during the long boom, something that has diminished its moral authority to tell other countries what to do now. The pact was much criticised as having no teeth, no way of imposing the fiscal rules it set out, but actually it has long been evident that the flawed design was even more of a problem.

So there has to be a new agreement and the Eurozone is inching towards that now. On Monday night the Council of Ministers announced some measures that are supposed to increase fiscal discipline and guard against imbalances. It is trying to find ways of warning of property bubbles and the like, things that might destabilise economies. But it is all very vague. In practice what is imposing discipline on the fringe Eurozone countries is not edicts from Brussels or Frankfurt but direct pressure from the financial markets. A European task force is trying to figure out sanctions on countries that break the rules in the future, together with new rules on indebtedness, and the reports coming out suggest that it is making slow progress.

Part of the problem is that it is all fiendishly complicated. As Barclays comments, reporting on the progress, or lack of it: "The task force leaves the task of defining debt levels and imbalances to the Commission." It would factor debt maturity, currency denominations, reserves, and implicit and explicit liabilities into the EU's calculations but it also asks the question whether the impact of pension reforms should be a factor.

None of this, I am afraid, bodes well. Markets hate complexity. All they need to know is how likely a country is to be able to repay its debts as they fall due. That judgement defines the risk premium that the borrower has to pay over the best-rated borrower, in the case of the Eurozone that being Germany. Lenders have other places to go. At the moment countries such as Mexico seem to be higher-rated than several middle-sized European nations.

So the new post-Maastricht arrangements have to do two things. They have to give Germany comfort that it will not be called on to bail out country after country as it did in the case of Greece. And they have to be credible to financial markets. The first inevitably requires a complex set of rules and sanctions, because within the European context that is the only way to enforce discipline. The second requires simplicity, coupled with some strong counter-cyclical element, rules for good times as well as bad. It will be very difficult to satisfy such different masters but of course it is vital that this should be done. The sort of cuts that the UK is imposing (as indeed in greater or lesser measure are all other European countries) are what happens if you don't have adequate rules in the first place.

Foreign lessons

Add the UK spending cuts to the Eurozone discussions noted above and it is easy to come away with a sense of despair about Europe's economic prospects. We have this huge debt burden; we have understandably angry voters; and we are being undercut by lower-waged economies in Asia. But while I don't think we should in any way play down the gravity of the situation we face, it is right to remember that there is huge scope within Europe to learn from each other.

Some ways in which we might do so are set out in a new paper from the McKinsey Global Institute, work that deserves a wider audience. The thrust of its argument is that Europe's economic performance has lagged behind the US for the past 15 years, a theme accepted by the so-called Lisbon Agenda, the EU plan to make Europe a more competitive economy. McKinsey points out that were the laggards in Europe (and performance lags in different areas in different countries) to reach the standards of the leaders, then the region could add between 4 and 11 per cent to its GDP per head, and without cutting holidays or leave.

Part of the key is using the European workforce better: increasing participation rates, using more part-time labour, improving markets, using cleverer regulation and so on. One particular area where Europe lags behind the US is in service industry productivity. Since services account for some two-thirds of the economy, there is clearly huge scope here. Of course there will be cultural limits to integration. No one should want to persuade Italians to behave like Scandinavians – the idea is absurd – or vice-versa. But the point that there are some quick wins to be had is hard to avoid. Surely we can learn from each other?

For further reading :

'Beyond austerity: A path to economic growth and renewal in Europe', by McKinsey Global Institute. Downloadable from www.mckinsey.com